How to trade the Fed’s rate decision

The Federal Reserve (Fed) is the central bank of the United States (US). A central bank usually provides financial and banking services for its country’s government and commercial banking system.

It also issues the local currency and implements monetary policy. Each decision has a vast impact on the value of the local currency, and therefore Forex (FX) traders pay close attention to each announcement.

The Fed meets roughly every six weeks, or eight times a year, for two consecutive days, and announces its decision afterward. The decision is made by a limited number of Fed officials known as the Federal Open Market Committee (FOMC).

The Fed’s upcoming announcement is expected to be the most relevant of the year, as the central bank is finally set to change its monetary policy.

Does the Fed’s Decision Offer Opportunities for Traders?

Indeed, Fed decisions usually trigger volatility in financial markets.

In general, interest rate changes affect all businesses and households. Simply put, higher rates increase money costs, resulting in limited consumption. The Fed raises rates when it wants to reduce consumption and thus inflation.

The opposite scenario also applies. Lower rates tend to stimulate consumption and thus economic growth.

At the same time, raising rates usually leads to a stronger currency, in this case the US dollar (USD), while lowering them usually weakens the currency.

There is a caveat, however: market players usually anticipate the decision and price it in, in this case by selling USD in anticipation of the announcement.

The U.S. dollar DXY index, which measures the value of the U.S. dollar against a basket of major currencies, fell in the days ahead of the Fed meeting as investors broadly expect the central bank to cut interest rates.

Volatility in this type of event is usually related to the deviation between market expectations and the actual decision.

What is the Fed expected to do in the next meeting in September?

Ahead of the announcement, investors priced in a 25 basis point (bps) discount. Some market participants even believe the Fed will opt for a more aggressive 50 bps rate cut.

In addition to the decision itself, the Fed will release the Summary of Economic Projections (SEP), a report that provides information on the economic outlook and expectations of FOMC members.

The paper provides officials’ perspectives on key economic figures such as real GDP growth, the unemployment rate and inflation. In addition, the SEP projects the federal funds rate, which is the interest rate at which banks lend to each other.

The SEP does not provide future actions or levels of economic improvement, but only presents policy makers’ perspectives on them.

SEP is the second most relevant factor. In fact, if the Fed delivers a rate cut as expected, that is what may actually trigger a volatile reaction in the USD. Once again, the bigger the surprise, the wilder the reaction on the FX front.

Summary of June Economic Projections. Source: Federal Reserve

In this case, investors anticipate a dovish bias, meaning a conservative document that suggests further rate cuts in the coming months. A huge surprise would be if officials, including Chairman Jerome Powell, take a hawkish stance, signaling that the rate cut is a one-off, rather than the start of a trend toward lower rates.

Finally, the Fed will publish the Statement of Monetary Policy, a summary of how and why policymakers arrived at the announced decision.

What are the different scenarios and how to trade the September Fed decision?

As said, the reaction of the USD will depend on the Fed’s ability to surprise investors.

Interest rates will trigger the initial reaction. If policymakers keep rates on hold, this would be an unexpected outcome and would be interpreted as a driver, pushing the US dollar higher at the FX level.

However, officials are unlikely to do so, as they usually refrain from triggering volatile market reactions.

A 25 bps cut could put some pressure on the USD, while a higher level of 50 bps could put the USD on a bearish trajectory.

Speculative interest, however, will quickly jump into economic projections. If the Fed appears worried about growth and revises its outlook downward, it will send a dovish message.

Main events related to the September Federal Reserve decision. Source: FXStreet

Given that investors are somewhat anticipating, the USD could fall. However, once again, the reaction will be far less relevant than what might be seen in a hawk stance.

Generally, and unless the message is very clear from all sides, the market would need about 15 minutes to find its way. The initial reaction could be erased and the USD could change course quite quickly after that.

Once the dust settles and there is a clear path for the Greenback, the most likely scenario is that such a directional move will resume once Asian traders get to their desks.